Forex traders should recognize that “risk appetite,” a phrase that describes investors’ willingness to take on risk, affects the currency markets. When investors feel confident about their investments, they may take on more risk and buy one currency over another. When they feel less confident, investors may buy a safer currency and cut back on their risk.
Risk Appetite
One of the best examples for “risk appetite” in the foreign exchange market is that of the AUD/JPY pair. Australia has a high-yielding currency, whereas Japan has a low yielding currency. Thanks to the interest rate differentials, investors can buy AUD/JPY to make money in a carry trade.
If the AUD yields 4.5%, and borrowing in JPY costs .25%, then a forex trader earns 4.25% on his or her total investment each year. If the investor were to invest $10,000 to make the trade, he or she would earn $425 annually in interest. With leverage, the investor might put up only $1,000 or his or her own money, and thus make a 42.5% return on the initial investment.
This seems to be a relatively risk-free trade, right? You’re bringing in 42.5% each year and the currency market doesn’t even have to move!
It’s not so clear cut. The AUD/JPY trade can be one of the most risky.
The Risk
AUD/JPY is a risky trade because thanks to the large profits available in the interest rate differentials, traders have a tendency to leverage up big time to buy Australian dollars with Japanese Yen. In using lots of leverage, a small move in the price of the Australian dollar can greatly affect a trader’s profit.
Example scenario: You purchase AUD/JPY at 20:1 leverage, earning you 4.25% per year on the whole investment, or 85% on your actual investment.
Possible outcomes:
- The AUD/JPY pair rises, and you earn the interest plus the increase in the currency values.
- The AUD/JPY pair stays flat, and you earn the interest.
- The AUD/JPY pair falls by 5%, and you lose everything.
Number 1 and number 2 are fantastic outcomes. Either you’ll earn an annual 85% return on your investment, or even more on rising AUD. Number 3 is a terrible outcome. Because you were leveraged at 20:1 margin, a 5% change in the price of AUDJPY is enough to erase your total investment.
When there are a lot of traders in the market using a lot of leverage, the volatility in the price tends to grow. When there are selloffs, they are strong, forceful, and quick. When there are buying sprees, the price rises with immediate strength.
The Australian dollar does well in less risky markets, but in the next article we’ll show you how the US Dollar performs when investors become fearful.
